Cheap vs Expensive Factors

Are Expensive Factors More Risky?

May 2020. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Factors can be valued like stocks
  • Factor valuations have not changed structurally over the last 30 years
  • Cheap factors outperformed expensive ones on average

INTRODUCTION

Tesla (TSLA) breached the $100 billion market capitalization in January 2020 and became the most valuable car manufacturer globally. However, valuing the company is challenging given the growth profile, complexity of the business, and erratic CEO. It is not yet profitable and cashflow is negative, which means that traditional valuation metrics based on historical data are currently less applicable to Tesla.

Investors could consider that Tesla sold less than 400,000 cars in 2019, compared to more than 6 million for Volkswagen (VW), which is valued at $87 billion. Tesla might seem extraordinarily expensive from this perspective, but that is similar to previous years.

Tesla and a few similar names like Netflix represent the antithesis of value investing and have been defying the expectations of most investors, especially of short-sellers. However, there is still very little research that encourages buying expensive stocks, despite the lost decade in value investing since the global financial crisis in 2009. Research continues to support the Value factor, which has been validated in equity markets globally as well as across asset classes in recent years.

Investors hoping for a recovery in value investing could apply a valuation-based approach to the factor itself, but there is limited research in this area.

In this short research note, we will explore equity factors and valuations.

FACTOR VALUATION SPREADS

Factors can be valued like stocks based on fundamental metrics. We calculate the average price-to-book multiples of the long and short portfolios of common equity factors as well as the difference between those, which is termed the valuation spread. The higher the spread, the more expensive a factor is from a valuation perspective (read Measuring Factor Crowding via Valuations).

It is worth highlighting that factors exhibit structurally different valuation spreads. T